How Rule of 55 Works

I’ve been noticing a larger number of people who want to retire before 65. But since many contribute to their 401ks, they are left wondering how to actually access or plan for it it without a penalty.

There are many exceptions to 10% penalty such as (from the IRS list):

1. After participant/IRA owner reaches age 59½
2. Distributions up to $5,000 per child for qualified birth or adoption expenses
3. Up to $22,000 to qualified individuals who sustain an economic loss in a federally declared disaster
4. Victim of domestic abuse by a spouse or domestic partner, up to the lesser of $10,000 or 50% of account
5. Qualified first-time homebuyers, up to $10,000 (IRA only)
6. Unreimbursed medical expenses (>7.5% AGI)
7. Health insurance premiums paid while unemployed (IRA only)
8. Qualified higher education expenses (IRA only)

Some time back ago, I shared a newsletter about a 72(t) plan that you can create to start withdrawing earlier by establishing series of substantially equal periodic payments. But, there is also a Rule of 55.

Rule of 55

This rule is more flexible than a 72(t) plan and much simpler to execute.

It applies to individuals between 54 and 58 years old and allows you to withdraw from a 401(k), 403(a), or 403(b) without the 10% penalty:

In simple terms, if you quit your job in the calendar year when you turn 55 (or 50 for qualified public safety employees) or older, you can start withdrawing from your retirement plan. The reason for separation does not matter.

For example, if you are 54 years old, quit your job in May, and turn 55 in December, you are eligible to withdraw from your 401k without a 10% penalty.

However, if you quit your job at 52, you cannot start withdrawing at 55 without incurring the 10% penalty, since you separated from service before reaching age 55.

A strategy

Let me show you why it’s also crucial to plan ahead:

Because Rule of 55 only applies to the entire balance sitting in your current employer’s plan at the time you separate, not just money you contributed while working there.

That’s why many people use the “rollover then quit” strategy, where your once old 401(k) or rollover IRA can be rolled into your current employer’s plan, and all of it will become eleigible under the Rule of 55 when you leave that job (obviously as long as you reach age 55 during the calendar year). Of course, a major limitation is that not all plans allow rollovers (but most do)

A big limitation to a Rule of 55 is that the 401(k) plan must allow post separation withdrawals in the form you want. This is because some plans force a full lump-sum distribution or don’t allow partial withdrawals to former employees. This is extremely important to clarify with your employer.

Qualified Public Safety Employees

If you are a qualified public safety employee, you are eligible to start withdrawing after the year in which you turned 50. The definition of qualified public safety employees includes:

• Any employee of a State who provides police protection, firefighting services, emergency medical services, or services as a corrections officer
• Federal law enforcement officers,
• Federal customs and border protection officers,
• Federal firefighters,
• Air traffic controllers,
• Nuclear materials couriers,
• Members of the United States Capitol Police,
• Members of the Supreme Court Police, and
• Diplomatic security special agents of the United States Department of State.

Final thought

In the end, there are many strategies you can utilize to avoid paying taxes or penalties. Remember, retirement is just a number in your investments. My goal with these newsletters is to show you strategies for paying less tax, improving your finances, and achieving freedom.

See you next Saturday

MC, CPA